Of Black Swans and White Chipmunks

Taleb’s paragon of fat tails is instead Benoit Mandelbrot, whose research on cotton prices also showed non-normal behavior. It’s worth noting that Mandelbrot’s name appears no less than 43 times in Fama’s1963 paper, and that Taleb didn’t become enamored of Mandelbrot until meeting him nearly a half century later.

Much of the book recounts Spitznagel and Taleb’s many triumphs, beginning with the “f*** you money” made by Taleb in the options market in October 1987, and again during the debt crises of 1997–1998, the global financial crisis of 2008–2009, and during the intense but brief COVID-related market swoon in March 2020. (In Taleb’s taxonomy, those events were “gray swans,” adverse events known to occur infrequently, versus true “black swans,” which have never been seen. A cynic might say that there are no black swans, only the history you haven’t read.)

Patterson tells us that Universa’s (Taleb and Spitznagel’s hedge fund) average annual return from 2008 to 2019, as audited by Ernst & Young, was 105% per year; an April 2020 newsletter informed clients that it had clocked a 3,612% return the previous month.The problem with those purported returns is twofold: The first is the denominator; If you’re paying $200 per month to insure a $500,000 home, you could say that you’ve made a 249,900% return on your premiumin the month it burns down, but that calculation ignores the cumulative present value of the decades of premiums before they finally paid off.

The second problem is the term “average return,” coupled with the opacity of Universa’s pronouncements. Is the Ernst & Young figure an arithmetic or ageometric average? We just don’t know, and with put options, it makes a big difference. If, say, Universa’s strategy made 1,260% in 2008 but all its puts expired worthless the next 11 years, then, yes, the arithmetic average of those returns over the 12 years would indeed be 105%, but the overall total geometric return would be bupkes, zero.

Obviously, the above is an extreme example; no sane investor allocates 100%, or even 10%, of their assets to something that returns 0% in nearly all months; Taleb and Spitznagel would correctly point out that a stand-alone strategy return is meaningless, since the proper use of their strategy is to add a smidge of it to an institution’s risky assets to take the sting out of the worst years, and thus improve its overall return. That said, if that 105% reported return is an arithmetic average, that wouldn’t be kosher.

Patterson gives us a back-of-the-envelope way of examining how one might fold selling out-of-the-money puts into one’s overall portfolio. Spitznagel tells him that in 2008 some foolish traders sold him one-month 20% out of the money puts on the S&P 500 in for approximately 90 cents that paid off $60 in October of that year, for a one-month return of about 6,600%. It so happens that in the 1,163 months between July 1926 and May 2023, the S&P 500 fell by more than 20% exactly five times. So if the XYZ pension fund theoretically had, beginning in 1926, invested 1% of its assets in those S&P puts and the other 99% in the S&P 500 index, then in the worst five of those months its returns would have improved by about 66%, but those five lagniappes would been overwhelmed by areturn drag of 1% per month: Instead of earning a 10.26% market return, a portfolio hedged with 1% of the Universa strategy would have made an annual 1.09%.On the other hand, if we give this strategy a mulligan and award the 66% bonus in the23months with only a 15% market decline, the portfolioreturn rises to a market-beating 12.64% per year. To extrapolate this paradigm a bit, the strategy has to pay off roughly at least once every five years to improve the return of an all-stock portfolio.

Admittedly, the above is a bit of a cartoon – for starters, the payoffs to options strategies aren’t linear, as assumed above, and presumably Universa does have a secret sauce that avoids at least some of the premium losses. On the other hand, this portfolio-wide case for tail insurance assumes that Universa’s clients reinvest the proceeds from the winning periods back into stocks at depressed prices; given the poisonous psychology of market panics and the spotty history of institutional investor discipline, this is a strong assumption indeed. Moreover, no monthly declines of more than even 15% occurred between 1940 and 1973; just how many institutional investors will tolerate a third of a century of uninterrupted portfolio bleed?

There’s an even bigger problem with this strategy, which is that the writers of put options arenot the happy idiots portrayed by Taleb and Spitznagel; they’re insuring you against stock losses and expect to be compensated for the risk of doing that, an expectation confirmed by a large body of empirical literature demonstrating that short-volatility strategies afford generous long-term returns in compensation for when their risk turns up, as occurred in 2008 and 2020. Absent publicly available data on Universa’s return series, some skepticism is in order.(For a superb overview if this issue, see the article in The Washington Post penned by Aaron Brown, a well-respected quant, “Universa’s 3,612% Return Is Legit (But With an Asterisk”).)

There’s an even bigger issue with the Universa strategy, at least for retail investors. In reality, market risk comes in two flavors: shallow risk, in which dramatic price falls quickly reverse; and deep risk, which produces decades-long loss of purchasing power that adversely impacts future consumption. All the market panics covered in The Chaos Kingsconstituted at worst shallow risk, and at best, opportunity for the disciplined, long-term shareholder. Like many who comment on Taleb’s work, I can’t resist inventing a new zoological metaphor, namely, the white chipmunk: a dramatic, headline-grabbing market decline that the disciplined andprudent individual investorboth motors through and barely remembers several years hence.

While examples of deep risk abound in financial history (for example, the post-1990 Japanese stock market or the U.S. bond market between 1940 and 1980, to say nothing of inflation in Germany, Hungary, and Zimbabwe), Patterson doesn’t deal with them, and many of Spitznagel and Taleb’s strategies wouldn’t survive the worst of them, if for no other reason than that their counterparties willhave vanished.

Famaoffered this typically understated assessment of the practical significance of fat-tailed returns: “For passive investors, none of this matters, beyond being aware that outlier returns are more common than would be expected if return distributions are normal.” He then went on to note that, in contrast to the individual investor, fat tails are indeed a big deal for the options trader; he might also have added that they also matter to professional investors in general, for whom even a brief rough patch can be career-ending.

To wit, what Taleb, Spitznagel, and Patterson consider a large-feathered beast is only a cute tiny rodent to the unleveraged retail investor possessed of adequate discipline and cash reserves and is thus not worth insuring against. Moreover, Taleb’s famous advice to small investorsleaves one’s head seriously scratched: 90% Treasury bills and 10% in high-risk ventures, both of which expose one to massive swans of whatever color you might choose – the T-bills are prey to the distressingly high incidence of hyperinflation in financial history, and any list of speculative ventures carries the very high probability of missing one of that playground’s rare winning lottery tickets.

The book also surveys wider societal black and gray swans, focusing mainly on pandemics and global warming. Patterson portrays Taleb and hedge fund manager William Ackman as two of the pandemic’s major heroes, prophets in the wilderness who sounded a prescient alarm with the blinding insight that the virus’s spread was exponential.

Please. By early January 2020 public health officials abroad and in the U.S. were already apoplectic, and medical students and public health trainees have for generations been tortured by the Kermack-McKendrick equations, whose initial exponential trajectories were by that point being extensively massaged by the world’s most powerful epidemiological engines.

Pandemics seem to particularly excite Taleb’s proclivity to catastrophizing. To take a small example, he endorses the oft-repeated conventional wisdom that today’s hyper-connected world greatly heightens pandemic risk and predicts that this risk will continue to grow with burgeoning air travel.

That’s a reasonable hypothesis, but history has conclusively tested it. Consider that the initial 14th century wave of the bubonic plague killed approximately a third of Europeans, and as much as nine-tenths of some Asian populations. This astronomical death rate occurred precisely because of the absence of facile long-distance transport: As the historian William H. McNiell famously pointed out, premodern transport inefficiencies separated the world’s disease pools, and thus left entire populations with zero immunity to their neighbors’ diseases, as occurred most spectacularly after 1492, whenthesmallpox and measles brought by Europeans to the New World may have killed upwards of 90% of its native inhabitants.

In the wake of World War I, influenza killed about 21 million people – “only” about 1% of the world population. The pandemic’s official global death toll is about seven million, or0.1% of the planet’s inhabitants, although excess death statistics suggest a figure two to three times that; had not COVID’s coronavirus relatives, a frequent cause of the common cold, been circulating around the planet for a long time and endowed populations with a modicum of immunological cross-reactivity to the new COVID strains, the death toll would likely have been far higher.

It thus seems that over the past several centuriespandemics may be becoming less, not more, of a threat to the average world citizen. While improving nutrition, public health interventions, and acute medical care deserve much of the credit for this, it also seems likely that modern transport’s facilitation of rapid disease-pool mixing prevents the zero-immunity powder kegs that touched off premodern pandemic holocausts; this in no way implies, of course, that we should be complacent.

Patterson’s treatment of global warming is even more mystifying. He devoted page after page to how the problem worries, of all people, money managers. (One of them was so concerned about the planet’s fate that he founded a hedge fund to short petroleum companies and go long alternative energy ventures.) By contrast, the Intergovernmental Panel on Climate Change, the organization spearheading the world’s response to the problem, gets two brief mentions.

Most curious of all is the book’s neglect of what is obviously the world’s foremost existential threat, an accidental or intentional nuclear holocaust, which on several occasions came within a hair’s breadth of immolating the planet, and whose specter again looms with the Ukraine conflict and with the growing geostrategic rivalry with China. While the consequences of climate change will be fearsome, they’re not in the same league with an exchange of more than a few dozen thermonuclear warheads.

If you’re looking for a rollicking good read about Nassim Taleb, Mark Spitznagel, and their fellow financial catastrophizers, then pick up The Chaos Kings. But for a cold, sober look at the world’s financial and societal risks, you’re better off elsewhere. Concerning the problems attendant to an increasingly complex and unstable financial system, start with Richard Bookstaber’s A Demon of Our Own Design; for the risk of nuclear annihilation and how close it came to pass on multiple occasions, consult Eric Schlosser’s frighteningCommand and Control; if you want the in-depth story of the pandemic’s actual heroes, read Michael Lewis’ The Premonition; and for a wide-angle view of humanity’s existential threats, I cannot recommend highly enoughToby Ord’s superb tour d’horizon of the subject, The Precipice.

William J. Bernstein is a neurologist, co-founder of Efficient Frontier Advisors, an investment management firm, and has written several titles on finance and economic history. He has contributed to the peer-reviewed finance literature and has written for several national publications, including Money Magazine and The Wall Street Journal. He has produced several finance titles, and four volumes of history, The Birth of Plenty, A Splendid Exchange, Masters of the Word, and The Delusions of Crowds about, respectively, the economic growth inflection of the early 19th century, the history of world trade, the effects of access to technology on human relations and politics, and financial and religious mass manias. He was also the 2017 winner of the James R. Vertin Award from the CFA Institute.

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